The coronavirus pandemic has changed the way we work, play, and invest. Working from home is the new normal. Outdoor walks, at a safe distance from family and friends, have replaced sporting events, happy hours, and backyard barbecues. And investing has evolved, too, as more investors demonstrate an increased appetite for companies with good records on environmental, social, and governance (ESG) practices.
According to Morningstar, more than $10 billion, net, flowed into 314 different open-end and exchange-traded ESG funds in the first quarter of 2020. That's an increase of more than 20% relative to the fourth quarter of 2019. The increase alone is impressive, but the timing is even more so. It was also during the first quarter of this year that the S&P 500 lost about 30% of its value. The average ESG fund, however, fell only 12.2%, according to a Bloomberg analysis.
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So, what's behind that resilience? One factor is that ESG funds have less exposure to industries that were hardest hit by the coronavirus, such as energy stocks. But another dynamic in play is the tendency for investors to swap out risky positions for higher-quality ones in times of market turmoil. Companies that rank well on ESG metrics often also bear the markings of quality, including strong governance and low volatility. That naturally positions ESG funds to benefit when markets go soft.
COVID-19 highlights ESG practices
In the first quarter, the coronavirus pandemic shed light on how well ESG funds can perform in turbulent markets. Going forward, COVID-19 will continue to bring attention to corporate ESG practices, particularly those in the social category.
Corporate social practices encompass employee safety, labor standards, and the company's support of its local community. Those issues are particularly relevant in the COVID-19 era, as corporations have struggled to balance employee safety with the financial needs of their communities. Tyson Foods (TSN 0.49%), for example, initially resisted calls to close its Waterloo, Iowa, plant in April, even as COVID-19 cases spread through the workforce. One argument for remaining open was the impact the closure would have on local farmers.
ESG funds can be controversial, too
Issues of employee safety in light of COVID-19 will continue to make headlines. And, given the uncertain economic outlook, investors should lean toward more resilient positions. Those circumstances bode well for the continued popularity of ESG investing and ESG funds. But investors should know that ESG funds aren't without their own controversies.
In 2019, for example, Vanguard admitted that it accidentally included a gunmaker, an oil services company, and other undesirable positions in its ESG funds. The mistake, according to Vanguard, was related to the screening process used by FTSE Russell, the funds' index provider. Vanguard had already sold the offending positions by the time it notified shareholders of the snafu.
Even without those kinds of oversights, ESG funds vary widely in the types of companies they hold. The standards that fund managers use to build their portfolios can range from rigid to downright lax. On the rigid end of the spectrum, a fund might exclude all businesses that operate in controversial industries, like nonrenewable energy and tobacco. Another fund might hold a tobacco company, for example, if it performs better on ESG metrics than its competitors.
Choosing ESG funds
If you like the idea of supporting sustainable business practices -- either because they're quality investments or because they're good investments -- do some research before you dive in. Read the fund's prospectus. Learn how the fund evaluates and selects positions for the portfolio. Review the fund's major holdings, as well as its track record of performance. And once you narrow your choices to a few options that match your values, compare their expense ratios. All else being equal, the lowest expense ratio is your best option. For all funds, the expense ratio is one of the best indicators of future fund performance.
There's nothing like a global health crisis to redefine priorities. If the coronavirus pandemic has you in search of investments that are higher quality or more friendly to the earth and its people, the right ESG fund can serve both needs. As with all investments, do your homework on your ESG fund choices -- so you land on one that aligns with your worldview.
